I was surprised the Fed actually went ahead and raised rates in December — but not surprised by the negative reaction of global stock markets. I sympathise with the Fed’s predicament. There were already obvious signs of distress in the junk bond market, continuing weakness in emerging market economies and currencies and growing evidence of economic slowdown in western economies. However, the asset price bubbles in stock and real estate markets continued to inflate, taking markets to historically elevated valuations and giving the, perhaps, false impression that all was well in underlying economies. This view was helped by strong employment numbers in the US and improving employment trends elsewhere in western economies.

The need to ‘normalise’ rates appears to have been thought appropriate to give the central bankers some policy options should economic activity turn down again. The US economic recovery was already one of the longest post war, albeit one of the most anemic, and should it turn down due to some unforeseen shock there would have been precious little the Fed could do with ZIRP still in place and their balance sheet already inflated from past QE.

The big question is of course what happens now. To answer that question I think we have to put where we are today into context. Since the financial crisis, global government and corporate debt has risen faster than GDP to levels way above where they were in 2008. Despite this, bond yields have fallen due to the combination of ZIRP and QE. This in turn has allowed stock markets to rise far faster than corporate profits, in part because price earnings ratios are a reciprocal of interest rates — but also because there was no reasonable alternative for large institutional investors.

Inflation has been absent, with many economies experiencing disinflationary if not deflationary tendencies, despite the best efforts of central bankers. The collapse of commodity prices has exacerbated this trend. Emerging market economies have been weakening for some time despite currency depreciation, whilst the western economic recoveries are not yet clearly self-sustaining. Most leading, and some coincident, economic indicators are already suggesting a continuation of the weakening trend; for example, global shipping rates as measured by the Baltic Dry Index are down nearly 50 percent over the last year.

All of which confirms the economic and financial world was in a pretty precarious state to cope with a rate rise. Only 0.25 percent, and you might reasonably respond, but it was also a doubling of rates after many, many years of ultra-low rates and build-up of debt to pay for ever higher asset prices.

The Fed’s resolve is clearly being tested. It appears we have stock market vigilantes pushing prices down to encourage the Fed to not raise further and perhaps even reverse the rate rise. This puts moral hazard back on the agenda, and a further postponement of the evil hour when debts have to be repaid and stock prices decline to more reasonably reflect the level of underlying earnings.

Equity markets have rallied over the last week as central bankers in Europe and the US have opined on interest rates. Firstly Mario Draghi at the ECB kept rates on hold but more encouragingly said more QE was a possibility after the current programme concluded. Markets might have been concerned at this admission of potential economic frailty but instead chose to be grateful for the possible extra boost to liquidity. Similarly Janet Yellen at the Fed kept rates on hold and this time left open the possibility of a rate rise in December this year, in contrast to last month’s concerns about ‘international headwinds’ suggested no move till into next year.

This is similar to the stance suggested by Mark Carney to the annual meetings of the IMF and World Bank that it remains a possibility that UK rates may rise this year.
Meanwhile the economic news has continued to confirm a modest slowdown in growth and pretty much a complete absence of any inflationary pressures.

Clearly the central bankers continue to think it better to allow the unfortunate consequences of low interest rates to prevail over the risk that tightening too soon will choke off the still modest economic growth.

Most commentators are agreed that low interest rates and QE have been a major contributor to growing wealth inequality as asset prices, both tangible and intangible, have been boosted. The decline in bond yields has hurt pensioners both directly through lower annuity rates and together with other low risk savers indirectly through lower deposit rates.

This has led to greater risks being assumed by both savers and borrowers. For example, the amount of debt required to purchase property with vastly inflated prices by new owners has risen and only been affordable because of low rates. This leaves them vulnerable should either rates rise or prices fall or both.

When asset prices have been rising for a while it is easy to forget the devastating impact on the residual of two big numbers when one or both of them move in the wrong direction.

It leaves a delicate balance for the central bankers to maintain. Possible of course, but past history suggests not one they often get right.

Global equity markets have traded sideways over the last week consolidating the rally at the start of October. There has not been a huge amount of economic data to the influence the direction of the equity markets, and what data there has been has continued the modestly positive but slowing trend of the last several months.

The interest rate hawks at the Bank of England and the Fed have both given speeches this week outlining why they think rates should rise sooner rather than later. Ian McCafferty of the BoE told an audience at Bloomberg that to achieve their ambition of a gradual and non disruptive normalisation of policy after a long period in which rates have been at historic lows, they must not get behind the curve. As he has been a lone voice at the last three meetings in calling for a rate hike, presumably he thinks they are already behind the curve. John Williams at the Fed told Bloomberg something similar.

This leaves us still trying to determine whether the recent correction in equity markets will be just that, or turn into a more prolonged and deeper bear market. The bulls argue we are in a mid-cycle pause in economic growth and that the developed economies can continue to prosper despite the now fairly entrenched slowdowns in the emerging economies, China in particular. Europe, they suggest, is in the early stages of benefiting from QE. Also, that high equity valuations relative to their own history are no impediment to further gains, as was seen in the last several bull market peaks which topped out at valuations higher than most thought plausible. The apparent technical deterioration with a trend break and more new lows that highs can be dismissed as a temporary phenomenon should markets rally from here.

The bear’s response is that we have enjoyed the second longest equity bull market in history, driven mostly by rising valuations on the back of extremely loose monetary policy and which is about to become less loose. As short interest rates rise so will bond yields, undermining the flattering comparison equities currently enjoy. Corporate profits will be squeezed and the valuations put on them will shrink.

With markets driven at the margin, or by the ‘what have you done for me today’ principle, I am inclined to side with the bears.

Last week I wrote an article about unwinding QE for Pieria. I argued that the current high levels of government debt have left policy-makers with very few options in the event of another crisis or downturn. In the aftermath of another crisis, the Government wouldn’t be able to cut interest rates and raise borrowing, and yet more QE is going to leave the central banks owning all the world government’s debt.

I believe policy-makers should be in a position to administer prudent fiscal and monetary policy in the event of a crisis or downturn. I don’t think that is the case today in Western economies, nor will it be until QE has been unwound and interest rates normalised.

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Welcome to my website. I'm Gregor Logan, an independent management professional with over 35 years of experience in all asset classes, including equities, bonds, property, private equity, alternative assets and bonds. I previously held senior-level roles at MGM Assurance, Pavilion Asset Management and New Star Asset Management.